US Dollar Index and Treasuries: Where To From Here?

The DXY and yields are taking the more bearish of the two paths they faced coming into today -- bearish for equities, that is.

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As I did my homework this weekend, I noticed that both Treasury yields and the US Dollar Index (DXY) seemingly were at respective forks in the road. Either they would both break below important short-term horizontal line support coincident with a flight to safety (in Treasuries), or they would hold up above that support and rally higher (likely coincident with the "risk on" trade remaining en vogue).

Well, today's action is giving us a definitive answer to which path the two key charts chose to carve out – yields sliced through support, dragging the DXY down in the process. That action has predictably been coincident with the acceleration in short-term selling in US stocks.

So, the question is, "Where do things go from here?" In today's admittedly concise article, I will attempt to give my best guidance. On to the charts!

CURRENCIES

If today's break of support holds, the DXY likely has more work to do on the downside.

The chart of the DXY below shows the index breaking down below the key (for the bulls) closing peak from December 19, 2013 at 80.63. That break has me thinking this is the "c" wave of an "abc" correction lower for the DXY with an ultimate target range of 79.76 (most optimistic calculation) to 79.30 (most extreme calculation for this wave count / scenario). With either of those two targets, the down move for the DXY will be meaningful and "felt" by investors as the coincident action in bonds and stocks will be uncomfortable for those long of stocks and short of bond prices.

Click to enlarge

BONDS

The 10-Year Treasury (INDEXCBOE:TNX) yield also has more downside work to do before support comes into play.

The action in the bond pits reflects a short-term run to safety that started over a week ago – not just today. Today's action has just accentuated the short-term weakness that began shortly after the first of the year. The bond bulls stepped on the gas pedal Friday after the US jobs report showed surprising weakness – even as equities temporarily shrugged off the news. Once the risk bears saw nothing monumentally game-changing over the weekend, they came back swinging their sledge hammers pretty hard on Monday – and ultra-hard Monday afternoon.

Now, the 10-year yields appear to have room to fall still – probably down to 2.768% -- before any real support can be identified. A breakdown below that level would signal an even more pronounced sell-off in risk assets – so pay close attention once yields reach 2.768%.

The crowd of equity bulls that has amassed in recent months will likely not give up any of their bullish swag unless and until 1812 is broken on the downside for S&P futures. If such a break occurs (likely in conjunction with 2.768% being violated by Treasury yields), much more short-term upside will be opened up for stocks. My best guess is that an eventual test of the mid-December 2013 lows near 1760 will be tested eventually if 1812 is violated on a closing basis.

However, as of now, the bulls remain pretty much in control of the fight. If 1812-1813 holds up as support, they will be able to put a choke hold on the bears and force the indices to new highs.

Click to enlarge

For what it's worth, at my firm, we were stopped out of our emerging markets equity exposure earlier in 2014 and put some of that cash to work in hedging strategies using the Volatility Index (INDEXCBOE:VIX). The rest of our portfolio remains long to the tune of around 84%. That will change accordingly if trip wires are crossed to the downside.

SUMMARY

Overall, it behooves everyone involved in the markets to closely monitor the 1812 level in S&P futures as well as the 2.768% level on the 10-year Treasury yield. To me, whichever side wins the battle there will enjoy some more short-term success as the strong recent rally in risk assets is retraced.

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